Mergers

Restructuring Ownership:
Mergers & Acquisitions

Prof. Ian Giddy
New York University
Mergers and Acquisitions
z Mergers
& Acquisitions
z Divestitures
z Valuation
Concept: Is a division or firm worth more
within the company, or outside it?
Copyright 2004 Ian H. Giddy
Corporate Financial Restructuring 2
GULF
Mardi-Gras Negotiation
MARDI
Before-and-after
Valuation
GRAS
Signed Merger
Agreement
The Basics
IBM is considering the acquisition of Basix, Inc.
The shares are trading at a P/E of 11, far
below IBMs P/E of 18. Based on past
performance the company is expected to earn
$2 per share next year, an increase from the
current EPS of $1.93. If IBM acquires Basix,
the long-run EPS growth rate could be raised
to 5.5%. The Treasury bond yield is 4.5%, the
companys beta is 1.3 and the long run
market return is 11.5%. Is the company worth
buying at a P/E of 12? At how much of a
premium should we say fugedaboudit?
Basix
Use constant growth model
Before
Earnings
$ 1.93
Next year
$ 2.00
Growth rate
3.6%
Risk free rate
4.50%
Beta
1.3
Market return
11.50%
Req ret on equity
13.60%
Value
$ 20.05
P/E
10.4
Price
$ 21.23
After
$ 1.93
$ 2.00
5.5%
4.50%
1.30
11.50%
13.60%
$ 24.69
12.8
16%
Source: basix.xls
Telia/Sonera
March, 2002, FT. Swedens Telia is merging with Finlands
Sonera. Under the deal, Telia will offer 1.51 of its shares for
each Sonera share, a premium of 15.8 per cent to Sonera's
closing price. This gives Telia shareholders 64 per cent of
the new company, and Sonera's 36 per cent. Adding the
present value of E300m synergies promised annually from
2005 to the companies' combined market capitalization, and
dividing by the increased number of shares, suggests a
value of roughly SKr41 per Telia share, against yesterday's
close of SKr35.4. But execution risks are high. The
expected growth of this sector is 6-7% pa.
Those risks mean Sonera ends up with a miserly premium. But although it is back from the
brink of disaster, it has nowhere else to go. Governance arrangements look promising.
Yet while bringing in an outside chief executive ensures neutrality, it leaves strategic
questions unanswered. What happens to Telia's loss-making international carrier
business, Sonera's 3G ventures and its interests in Turkey and central Asia?
The strategic fit is not bad. Telia would acquire Sonera's market leadership in Finland, plus
Sonera's interests in their joint ventures in the Baltic states and Russia.
The biggest problem may be price. There are synergies on offer - Telia could shut down its
loss-making Finnish mobile venture, and crunch head office costs. But they appear
rather limited. The merged entity would not gain economies of scale in mobile to
compare with a Vodafone or an Orange. Telia may find it hard to make an offer that
does not destroy value for its shareholders, but is still worth Sonera bothering to accept.
The Gains From an Acquisition

Gains from merger
Synergies
Top line
Control
Bottom line
Financial
restructuring
Business
Restructuring
(M&A)
The Market for Corporate Control

When you buy shares, you get dividends;
and potential control rights
There is a market for corporate control
that is, control over the extent to which
a business is run in the right way by the
right people.
This market is constrained by
Government
Management
Some
shareholders
Example:
Allied Signals attempts
to acquire AMP, which is
located in Pennsylvania
Goal of Acquisitions and Mergers

z Increase
size - easy!
z Increase market value - much
harder!
Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost
of transaction]
z Synergy
z Gain market power
z Discipline
z Taxes
z Financing
AOL-Time Warner
Now..when did the

merger take place?
Motivations?
z Lessons?
z
AOL-Time Warner
Possible motivations
z Economies of scale and scope
z Diversification
z Access to new technology
z Regulatory arbitrage
z Hubris
Possible problems
z Overestimating synergy
z Slow pace of integration
z Poor strategy
z Payment in stock
z Overpaying
z Poor postmerger
communication
z Conflicting corporate cultures
z Weak core business
z Large size of target company
z Inadequate due diligence
z Poor assessment of technology
Who Gains What?

Target firm shareholders?
z Bidding firm shareholders?
z Lawyers and bankers?
z Are there overall gains?
z
Changes in corporate control increase the

combined market value of assets of the
bidding and target firms. The average is
a 10.5% increase in total value.
Gains to Bidding Firm Shareholders

There are positive returns to successful
bidders in tender offers
z For successful bidders in mergers,
evidence is mixed. It seems that returns
are around zero.
z For unsuccessful bidders in both tender
offers and mergers, returns are
negative.
z
Do Acquisitions Benefit Shareholders?

Successful Bids
Technique
Target
Bidders
Tender offer
Merger
Proxy contest
30%
20%
8%
4%
0
na
Note: Abnormal price changes are price changes adjusted to

eliminate the effects of marketwide price changes
Do Acquisitions Benefit Shareholders?

Unsuccessful Bids
Technique
Target
Bidders
Tender offer
Merger
Proxy contest
-3%
-3%
8%
-1%
-5%
na
The Price: Who Gets What?
Market value before deal

leaked
Value added by merger
Daimler
Chrysler
Combined
$52.8
$29.4
$82.2
$18.0
Merged Value
$100.2
Shareholders get
57.2%
42.8%
100%
Which is now worth
$57.3
$42.9
$100.2
Shareholders' shares of
the gain
Premium, as %
$4.5
$13.5
$18
9%
46%
AMP/AlliedSignal/Tyco
What defenses
did AMP
employ?
z Who won? Who
lost?
z
Equity Valuation:
Application to M&A
Prof. Ian Giddy
New York University
What's It Worth?
Valuation Methods
z Book value approach
z Market value approach
z Ratios (like P/E ratio)
z Break-up value
z Cash flow value -- present value of
future cash flows
How Much Should We Pay?

Applying the discounted cash flow
approach, we need to know:
1.The incremental cash flows to be
generated from the acquisition, adjusted
for debt servicing and taxes
2.The rate at which to discount the cash
flows (required rate of return)
3.The deadweight costs of making the
acquisition (investment banks' fees, etc)
Valuing a Firm with DCF:

An Illustration
Historical
financial
results
Adjust for
nonrecurring
aspects
Gauge
future
growth
Projected sales
and operating
profits
Adjust for
noncash
items
Projected free cash flows

to the firm (FCFF)
Year 1
FCFF
Year 2
FCFF
Year 3
FCFF
Year 4
FCFF
Discount to present using weighted

average cost of capital (WACC)
Present
value of free
cash flows
+ cash,
securities &
excess assets
- Market
value of
debt
Terminal year FCFF
Stable growth model

or P/E comparable
Value of
shareholders
equity
Equity Valuation in Practice

Estimating discount rate
z Estimating growth rate and cash flows
z Application to Optika
z Estimating synergies
z Application in M&A: Schirnding-Optika
z
Estimating Future Cash Flows
Dividends?
Free cash
flows to
equity?
Free cash
flows to firm?
The Gains From an Acquisition

Gains from merger
Synergies
Top line
Bottom line
Control
Financial
restructuring
Business
Restructuring
(M&A)
Optika
Optika
WACC:
ReE/(D+E)+RdD/(D+E)
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
Riskfree rate
Debt spread
Market risk spread
Value:
FCFF/(WACC-growth rate)
Revenues
-COGS
-Depreciation
=EBIT
EBIT(1-Tax)
-Change in WC
-Free Cash Flow to Firm
Cost of Equity (from CAPM)
Cost of Debt
WACC
Equity Value:
Firm Value - Debt Value
= 2681-250 = 2431
Firm Value
5%
35%
3125
89%
10%
1300
250
1.0
7%
1.5%
5.5%
T+1
3281
2920
74
287
187
16
171
12.50%
5.53%
11.38%
CAPM:
7%+1(5.50%)
Debt cost
(7%+1.5%)(1-.35)
2681
Optika & Schirnding

Optika
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
Riskfree rate
Debt spread
Market risk spread
Revenues
-COGS
-Depreciation
=EBIT
EBIT(1-Tax)
-Change in WC
Cost of Debt
WACC
Firm Value
5%
35%
3125
89%
10%
1300
250
1.0
7%
1.5%
5.5%
Schirnding
5%
35%
4400
87.50%
10%
2000
160
1.0
7%
1.5%
5.5%
Combined
5%
35%
7525
T+1
3281
2920
74
287
187
16
171
12.50%
5.53%
11.38%
T+1
4620
4043
200
378
245
22
223
12.50%
5.53%
11.98%
7901
6963
274
664
432
38
394
12.50%
5.53%
11.73%
2681
3199
5859
10%
3300
410
1.0
7%
1.5%
5.5%
Optika-Schirnding with Synergy

Optika
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
Riskfree rate
Debt spread
Market risk spread
Revenues
-COGS
-Depreciation
=EBIT
EBIT(1-Tax)
-Change in WC
Cost of Debt
WACC
Firm Value
5%
35%
3125
89%
10%
1300
250
1.0
7%
1.5%
5.5%
Schirnding
5%
35%
4400
87.50%
10%
2000
160
1.0
7%
1.5%
5.5%
T+1
3281
2920
74
287
187
16
171
12.50%
5.53%
11.38%
2681
Combined
5%
35%
7525
10%
3300
410
1.0
7%
1.5%
5.5%
Synergy
5.5%
35%
7525
86.00%
10%
3300
410
1.0
7%
1.5%
5.5%
T+1
4620
4043
200
378
245
22
223
12.50%
5.53%
11.98%
7901
6963
274
664
432
38
394
12.50%
5.53%
11.73%
T+1
7939
6827
274
837
544
41
503
12.50%
5.53%
11.73%
3199
5859
8074
Valuation in a Bidding-War Context
Case Study: The Acquisition of Conrail

Why merge Conrail and CSX?
z How was the CSX offer structured?
z How was Conrails resistance to an
unfriendly bid structured?
z How would you, as a Conrail
shareholder, react to the offer?
z Whats Conrail worth?
z
The Network
Conra il
R a ilroa d Ope ra tions
Operating Revenues
$3,686
Operating Expenses
3,230
Operating Cost Ratio (%)
87.60%
Railroad Employees
23,510
Total Carloads Originated (thousan
2,531
Revenue per Employee
$156,784
Fina ncia l R a tios (% )
Return on Sales
Return on Average Equity
11.4%
9%
CSX
N orfolk
S outhe rn
$4,819
3,951
82.00%
29,537
4,402
$163,151
$4,012
2,950
73.50%
24,488
3,435
$193,690
6.9%
15.5%
15.3%
15%
Conrail:
Obstacles to an Unfriendly Takeover
z
Pennsylvania
Fair
Value statute: bids >20% all get same price

Bidders voting rights maxed at 20% unless
management approves
Constituency statute: protect unions
z
Conrail
Break-up
fee to CSX
CSX has lock up option to buy 16m new shares
Poison pill (suspended for CSX): shareholders get
new shares at half price if outsider buys 10%
6-month no talk clause
Takeover Defenses
z
Poison Pills
Preferred flip-over stock

Flip-over rights
Flip-in rights
Poison put bonds
z
Shark Repellants
Limitations on board changes

Limitations on shareholder actions
Supermajority rules
Anti-greenmail limits on share repurchases
Fair-price provisions
Supervoting stock exchange offers
Reincorporation
Golden parachutes
Post-Takeover Bid Responses

z
z
z
z
z
z
z
Just Say No
Litigation
White Knight
Greenmail
ESOP
Pac-Man
Restructuring, including
Leveraged Recapitalization
Share Buybacks
Using cash for acquisitions
Divestitures
Going private
Liquidation
What is Conrail Worth?

z
Stand-alone value
Market
value: $71.00
Comparables P/E ratio)
Conrail:
$89/4.91=18x
Discounted
present value
Value to acquirer
z Value in bidding-war context
z
Comparables
Value
ValueIndicator
Indicator
Earnings
Earnings
Cash Flow
Cash Flow
Revenues
Revenues
Book
Book
Average
Average
Comparable
Comparable
Industry
Industry
Firms
Firms
Deals
Deals
Target
Target
Company
Company
Numbers
Numbersor
or
Projections
Projections
Estimated
Estimated
Value
Valueof
of
Target
Target
Conrail Valuation
Multiples
Average multiple
Number Firm value Debt value Equity valuEquity Value per share
Price/Earnings
17.19 $
5.69
Price/EBITDA
10.57
1017 10749.69
2094
8655.69
93.58
2094
6876.02
74.34
Price/Sales
2.41
3722
Price/Book
3.63
32.46
97.81
8970.02
117.83
How Much Premium Can a Buyer Pay?

Applying the discounted cash flow approach,
we need to know:
z
The incremental cash flows to be generated
from the acquisition, adjusted for debt
servicing and taxes
z
The rate at which to discount the cash flows
(required rate of return on equity)
z
The deadweight costs of making the
acquisition (investment banks' fees, etc)
z
Cost of losing out!
Gains From an Acquisition of Conrail?

Gains from merger
Synergies
Top line
Bottom line
Control
Financial
restructuring
Business
Restructuring
(M&A)
Conrail Valuation
CSX Valuation 1
Gain in Operating Income

3%
TV w. const growth m
After tax
35%
PV
NPV
1990.995
Shares
90.5
NPV per share
$ 22.00
Pre-merger
$71.00
Total
$ 93.00
Re
16.15%
Required return
=
=
Rf
6.83%
1997
0
1998
188
1999
396
2000
550
0
0
122
91
257
164
358
196
+
+
Beta
1.3
Mkt Risk Prem

7.17%
2001
567
4441
3255
1540

z
Stand-alone value
Market
value: $71.00
Comparables
Discounted present value
Value to acquirer
z Value in bidding-war context
z
A Higher Price for Conrail

Could Norfolk Southern make a bid?
z How? How much?
z Does this change what CSX has to pay?
z Answer: Yes!
z

Conrail Valuation
CSX Valuation 2
Re
16.15%
Required return
=
=
Rf
6.83%
Gain
Gain in Operating Income
3%
After tax
35%
PV
NPV
2634.565
Shares
90.5
NPV per share
$ 29.11
1997
0
1998
240
1999
521
2000
730
0
0
156
116
339
216
475
261
Opportunity Cost
Loss if rival gets target
3%
After tax
35%
PV
NPV
-682.571
Shares
90.5
NPV per share
$ (7.54)
1997
0
1998
-66
1999
-123
2000
-189
0
0
-43
-32
-80
-51
-123
-67
Pre-merger
Gain
Opp cost
Total
+
+
Beta
1.3
Mkt Risk P
7.17%
2001
752
5890
4317
2042
2001
-196
-1535
-1125
-532
$71.00
$ 29.11
$ 7.54
$107.65
But Where Are the Profits?

January 2001
http://www.railwayage.com/jun01/conrail_split.html
But Where Are the Profits?

NSC
S&P500
CSX
Summary: Whats It Worth?
Valuation
Liquidation
Dissolve
Break-up
Going concern
Comparables
Acquisition
PV Cash Flows
Synergies
Top line
Bottom line
Control
Business mix
Rival Advantage
Financial
Contact Info
Ian H. Giddy
NYU Stern School of Business
Tel 212-998-0426; Fax 212-995-4233
Ian.giddy@nyu.edu
http://giddy.org

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Restructuring Ownership:

Mergers & Acquisitions

Mergers and Acquisitions

Corporate Financial Restructuring 2

Corporate Financial Restructuring 6

Corporate Financial Restructuring 7

Corporate Financial Restructuring 8

The Gains From an Acquisition

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 9

The Market for Corporate Control

Goal of Acquisitions and Mergers

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 11

Corporate Financial Restructuring 12

Now..when did the

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 14

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 15

Who Gains What?

Changes in corporate control increase the

Corporate Financial Restructuring 16

Gains to Bidding Firm Shareholders

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 17

Do Acquisitions Benefit Shareholders?

Note: Abnormal price changes are price changes adjusted to

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 18

Do Acquisitions Benefit Shareholders?

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 19

The Price: Who Gets What?

Market value before deal

Which is now worth

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 20

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 21

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 23

How Much Should We Pay?

Corporate Financial Restructuring 24

Valuing a Firm with DCF:

Projected free cash flows

Discount to present using weighted

Terminal year FCFF

Stable growth model

Equity Valuation in Practice

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 26

Estimating Future Cash Flows

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 27

The Gains From an Acquisition

Copyright 2004 Ian H. Giddy

Corporate Financial Restructuring 28

Optika & Schirnding

Corporate Financial Restructuring 30

Optika-Schirnding with Synergy

Corporate Financial Restructuring 31

Valuation in a Bidding-War Context

Copyright 2004 Ian H. Giddy